Employment and Unemployment

Employment and Unemployment

The natural rate of unemployment and full employment
The natural rate of unemployment is influenced by structural and frictional unemployment. An economy will always experience these two types of unemployment because there will always be new people joining the labour market and technology will always reduce the demand for certain jobs. It occurs when the labour market is in equilibrium and is independent of the inflation rate. The natural rate of unemployment can be reduced by tackling structural and frictional unemployment, e.g. job information provision, education and training, encouraging mobility of labour, etc. 

Full employment is a situation in which all those individuals of working age that are willing to work at the prevailing wage rate have jobs. There is maximum and efficient utilisation of labour when there is full employment. It does not refer to a zero unemployment rate due to the inability to avoid frictional and structural unemployment. A low rate of unemployment, say less than 5%,  is viewed as full employment. But cyclical unemployment can be avoided at full employment. The actual rate of unemployment is equal to the natural rate of unemployment when there is full employment. If the actual rate of unemployment exceeds the natural rate, the economy’s actual output will be below its potential output. If it is less than the natural rate of unemployment, the actual output is greater than the potential output leading to inflationary pressure.

Equilibrium unemployment and disequilibrium unemployment

The labour market is in equilibrium when the aggregate demand for labour (ADL) is equal to the aggregate supply of labour (ASL) while disequilibrium occurs when the aggregate demand for labour and aggregate supply of labour are not equal. The aggregate demand for labour is the economy’s total demand for labour.  It is represented by the aggregate demand for labour curve which is downward sloping because as the real wage increases, the total demand for labour will decline and vice versa (Figure 1 below). Employers would substitute capital for labour if the real wage rate is increasing, thereby reducing their demand for labour. The wage rate that has been adjusted for inflation is known as the real wage rate. The aggregate supply of labour is the total supply of labour for the economy. The aggregate supply of labour curve slopes upward because more workers would like to work when the real wage rate rises and vice versa (Figure 1 below).

Equilibrium unemployment is the type of unemployment that remains when there is equilibrium in the labour market. This is when it is possible for every worker that is willing to accept the current wage rate to secure a job. But it is not every person that is looking for a job that will be employed when there is equilibrium in the labour market. It is not every person that is willing to accept the equilibrium wage rate (WE in Figure 1 below); of course, some would prefer to search for a higher-paying job or job with better working conditions. So, the difference between those who are searching for a job and those who are willing to accept jobs at the current wage rate represents equilibrium unemployment (QE to Q1 in Figure 1 below). The labour force (NL in Figure 1 below) comprises those who are working at the current wage rate and those who suffer equilibrium unemployment. Frictional, structural, and seasonal unemployment are the types of equilibrium unemployment.  Therefore, equilibrium unemployment occurs when people are not willing or able to take up a job because they are unaware of where suitable jobs are, lack relevant skills or are affected by changing seasons. 

Figure 1: Equilibrium unemployment

Graph showing equilibrium unemployment

Disequilibrium unemployment occurs when the actual wage (WD in Figure 2 below) rate exceeds the equilibrium wage rate (WE). There will be an excess of supply of labour over demand for labour at the actual wage rate, so many would not be employed. Q1 to Q2 represents disequilibrium unemployment. In addition, the actual wage rate does not fall to the equilibrium level immediately. The two types of disequilibrium unemployment are cyclical and real wage unemployment. Real wage unemployment occurs when the real wage rises above the equilibrium wage level; it may be caused by the activities of trade unions that bargain for higher wages for their members.  Sometimes, employers continue to pay their workers above the minimum wage or equilibrium wage rate even though they face challenges. This is to ensure that the workers are motivated to work harder and to reduce labour turnover.  An increase in the productivity of motivated workforce will eventually reduce costs and make the business more profitable. The reluctance may be because those workers have special skills that cannot be easily seen in the labour market. This is the efficiency wage rate. The efficiency wage is likely to be above the equilibrium wage rate and it could occur when there is cyclical unemployment. Cutting the wage rate to the equilibrium level may not reduce cyclical unemployment.

Figure 2: Disequilibrium unemployment

Non-accelerating inflation rate of unemployment (NAIRU)

This is the level of unemployment that does not lead to a rise in the inflation rate. There will be an increase in the inflation rate if the unemployment rate is less than NAIRU. This means there is insufficient productive capacity to meet aggregate demand and firms will have to pay higher wages to attract more labour. Consequently, firms would have to raise their prices to cover their increased costs.

If the unemployment rate is higher than NAIRU, there is spare capacity in the economy. The economy can produce enough products to meet up with aggregate demand. The demand for labour will decline; also, wages and inflation rate will decline.